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How the Euro Might be Derailed


The European financial officials are preparing their policy package to deal with the current crisis for the meeting scheduled next week. It is not clear whether any of the proposals will be able to stop the ongoing bank run. Here are some of the rumored proposals:

* Euro member jointly issued short term bills – in effect, short term euro bonds.

* A debt redemption fund as proposed by economic advisors to Merkel.

* New procedures for euro area banking supervision.

* Using the ESM to purchase peripheral nations’ bonds in order to reduce their sovereign interest rates.

French President Hollande is advocating the ESM purchase program.  He is also advocating that the ESM be given a banking licence linked to the European Central Bank’s balance sheet.  This makes sense as it addresses the solvency issue.

In the Eurozone we have a solvency problem and a crisis of deficient aggregate demand. Unfortunately, within the European Monetary Union these twin crises ultimately fall entirely in the realm of the issuer of the currency- the ECB, and not the users of the currency- the euro member nations. So without the ECB, directly or indirectly, underwriting the currency union, solvency is always an issue, whether that be Greece, Portugal, Spain, Italy or, indeed, Germany. Likewise deficient spending power has been exacerbated via the austerity imposed as a condition of the ECB’s help. It is akin to putting a patient on a drip feed, allowing him to recover, then breaking his legs again so that he remains bed-ridden.And that includes the banking system, which, to serve public purpose, requires credible deposit insurance, again meaning support from the issuer of the currency.

Chancellor Merkel says the Hollande proposal “is not up for debate”. She is also resisting the alternatives involving euro member jointly guaranteed financings. Why? Perhaps because they may be in conflict with the German constitution and the odds of a challenge are on the rise.

There has been much discussion recently in Europe of seemingly arcane technical details, such as ”Target 2” and other forms of ECB Lender of Last Resort activity, such as the Emergency Lending Assistance program (the “ELA”, which has largely kept Greek banks afloat over the past several months.  We won’t go into the details here except to say that they have all become germane in the context of Germany’s constitution.   All of the ECB’s lender of last resort programs have built up large contingent claims in Germany (as the largest creditor economy in the Eurozone), and these claims have been the subject of much heated domestic political debate.

Thus far, there has constitutional challenge in Germany to these programs specifically.This may be because Target 2 financings in particular are not well understood. They are a “back door” bailout financing. Their volumes are not widely appreciated. Many think they are simply financings of current account deficits on the periphery and are not debtor bailouts. In fact, the cumulative current account deficits are small relative to now prevailing Target 2 imbalances. No one so far may have dared to bring a challenge to the court. Once someone does the extent of Target 2 bailout financing and, for that matter, additional ECB back door bailout financings (via ELA and ECB repos) will be brought to light. Once there is a challenge there might be an adverse court ruling. That could end ECB lender of last resort financings. That prospect would imply that some banks with runs would have to suspend payments on deposits. The bank run could then become explosive. That could be sudden death to the euro.

As the Target 2 and other ECB lender of last resort positions increase, the contingent loss exposure of the German banking system increases if the euro zone blows up or one country defaults.. Perhaps that increases the odds of a constitutional challenge which would vastly intensify the current bank run. That is a major unrecognized risk to the euro arrangement.

Now policy makers in the Eurozone are talking about solving the bank run with a program of deposit insurance. That makes sense, but the problem is that a deposit insurance program would be a new initiative. That might be more readily challenged before the constitutional court. Chancellor Merkel may realize this. She may realize that a challenge to a deposit insurance initiative might bring to light the issue of the constitutionality of Target 2 and thereby threaten an even more intense run on the banks of the periphery of Europe.

It may be these considerations that have so far delayed any move by the EU to arrest the current bank run with the only truly effective bazooka – jointly guaranteed insurance in euros for bank deposits in all euro member nations.

In the end I believe there is already a bank run and it is escalating. The Europeans are working on a deposit insurance scheme. I expect this to go forward with German approval. The stakes are too high.

But a mere challenge to the constitutionality of Target 2 or euro wide deposit insurance could create fears of a cessation of ECB lender of last resort financing and subsequent bank suspensions of payments on deposits. That would intensify any bank run.

Why? Because if I’m a depositor in a Greek, Spanish or Italian bank and I think there is even the slightest possibility that an ECB-directed deposit insurance scheme could be nullified by a German court ruling, then I’ll raise to take my money elsewhere as quickly as I can.  No wonder the issue of capital controls is now being quietly discussed in Brussels.

This is the real reason why Mrs Merkel says that there are limits to what Germany can do on its own and why she continued to take such a hard line with Athens over the course of the Greek election campaign.. Of course, she rejects the alternative proposals because they are politically unpalatable, in part because she hasn’t been honest with her own electorate in spelling out what the real implications of Germany’s position is if the Eurozone blows up. She’s in a corner. This also explains why the Germans are so keen to involve entities like the IMF, because it helps get around this legal conundrum.

So we have a crisis in which what makes sense economically might prove politically and legally impossible for the Germans to swallow.  But what is legally possible is insufficient to forestall Europe’s mounting banking and solvency crisis.  We have truly entered the waters of Scylla and Charybdis.

MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Intitute. He can be reached at


MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Intitute. He can be reached at

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